Consider our loss-ALAE dataset, and – as in Frees & Valdez (1998) – let us fit a parametric model, in order to price a reinsurance treaty. The dataset is the following,

> library(evd) > data(lossalae) > Z=lossalae > X=Z[,1];Y=Z[,2]

The first step can be to estimate marginal distributions, independently. Here, we consider lognormal distributions for both components,

> Fempx=function(x) mean(X<=x) > Fx=Vectorize(Fempx) > u=exp(seq(2,15,by=.05)) > plot(u,Fx(u),log="x",type="l", + xlab="loss (log scale)") > Lx=function(px) -sum(log(Vectorize(dlnorm)( + X,px[1],px[2]))) > opx=optim(c(1,5),fn=Lx) > opx$par [1] 9.373679 1.637499 > lines(u,Vectorize(plnorm)(u,opx$par[1], + opx$par[2]),col="red")

The fit here is quite good,

For the second component, we do the same,

> Fempy=function(x) mean(Y<=x) > Fy=Vectorize(Fempy) > u=exp(seq(2,15,by=.05)) > plot(u,Fy(u),log="x",type="l", + xlab="ALAE (log scale)") > Ly=function(px) -sum(log(Vectorize(dlnorm)( + Y,px[1],px[2]))) > opy=optim(c(1.5,10),fn=Ly) > opy$par [1] 8.522452 1.429645 > lines(u,Vectorize(plnorm)(u,opy$par[1], + opy$par[2]),col="blue")

It is not as good as the fit obtained on losses, but it is not that bad,

Now, consider a multivariate model, with Gumbel copula. We’ve seen before that it worked well. But this time, consider the maximum likelihood estimator globally.

> Cop=function(u,v,a) exp(-((-log(u))^a+ + (-log(v))^a)^(1/a)) > phi=function(t,a) (-log(t))^a > cop=function(u,v,a) Cop(u,v,a)*(phi(u,a)+ + phi(v,a))^(1/a-2)*( + a-1+(phi(u,a)+phi(v,a))^(1/a))*(phi(u,a-1)* + phi(v,a-1))/(u*v) > L=function(p) {-sum(log(Vectorize(dlnorm)( + X,p[1],p[2])))- + sum(log(Vectorize(dlnorm)(Y,p[3],p[4])))- + sum(log(Vectorize(cop)(plnorm(X,p[1],p[2]), + plnorm(Y,p[3],p[4]),p[5])))} > opz=optim(c(1.5,10,1.5,10,1.5),fn=L) > opz$par [1] 9.377219 1.671410 8.524221 1.428552 1.468238

Marginal parameters are (slightly) different from the one obtained independently,

> c(opx$par,opy$par) [1] 9.373679 1.637499 8.522452 1.429645 > opz$par[1:4] [1] 9.377219 1.671410 8.524221 1.428552

And the parameter of Gumbel copula is close to the one obtained with heuristic methods in class.

Now that we have a model, let us play with it, to price a reinsurance treaty. But first, let us see how to generate Gumbel copula… One idea can be to use the frailty approach, based on a stable frailty. And we can use Chambers et al (1976)to generate a stable distribution. So here is the algorithm to generate samples from Gumbel copula

> alpha=opz$par[5] > invphi=function(t,a) exp(-t^(1/a)) > n=500 > x=matrix(rexp(2*n),n,2) > angle=runif(n,0,pi) > E=rexp(n) > beta=1/alpha > stable=sin((1-beta)*angle)^((1-beta)/beta)* + (sin(beta*angle))/(sin(angle))^(1/beta)/ + (E^(alpha-1)) > U=invphi(x/stable,alpha) > plot(U)

Here, we consider only 500 simulations,

> Xloss=qlnorm(U[,1],opz$par[1],opz$par[2]) > Xalae=qlnorm(U[,2],opz$par[3],opz$par[4])

In standard reinsurance treaties – see e.g. Clarke (1996) – allocated expenses are splited prorata capita between the insurance company, and the reinsurer. If denotes losses, and the allocated expenses, a standard excess treaty can be has payoff

> L=100000 > R=50000 > Z=((Xloss-R)+(Xloss-R)/Xloss*Xalae)* + (R<=Xloss)*(Xloss<L)+ + ((L-R)+(L-R)/R*Xalae)*(L<=Xloss) > mean(Z) [1] 12596.45

Now, play with it… it is possible to find a better fit, I guess…

May I try to influence your judgement about prorated ALAE being “Standard” in Excess of Loss contract?

In fact at least in EU this practise has been tempted by a few reinsurers with little success as the ceding companies are resisting. One could understand they like to keep their retention at the lowest posible level.

As a result this is most probably ALAE included in the loss which is to be considered as a standard.